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Trends and Uses of Equity

Derivatives
Presentation to 3rd Hedge Fund
Conference, Milan

Mickey de Lathauwer
Massoud Mussavian

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Trends, Responses and Implications

I. Recent trends in global markets

II. How have investors responded?

III. What does it mean for your investment process?

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I. Recent trends in global markets 3 .

Lower diversification within equities 3.Trends Recent big trends in global markets 1. Negative correlation of equity and bond returns 4 . Higher equity volatility 2.

Trend 1: Higher Equity Volatility Equity volatility is at high historical levels S&P 500 Daily Realized volatility 1929-Present 80 70 60 50 Volatility (%) 40 30 20 10 0 1929 1939 1949 1959 1969 1979 1989 1999 3 Mth Realised Volatility Source: FAME 5 .

Trend 1: …And Equity Markets Feel More Volatile Because higher risk has meant more negative returns Last Prior S&P Stock Risk Deciles 24 Months 5 Years Return and Risk S&P 500 Volatility 24.5% 6.7% Annualized Return 50 30 10 -10 2000-2001 -30 2002 -50 20 30 40 50 60 70 Annualized Volatility (Weekly Returns) Source: FAME 6 .5% 18.1% % Months 70 1998-1999 S&P Returns < -5% 37.

Trend 1: …And volatilities are volatile The range within which volatility trades is also at extreme levels 55% 55% DAX FTSE 50% 50% 45% 45% 40% 40% 35% 35% 30% 30% 25% 25% 20% 20% 15% 15% 10% 10% 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Source: FAME 7 .

FAME 8 .8 0.2 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Source: Goldman Sachs.4 0.0 STOXX50E DAX SP500 0.6 0.Trend 2: Diversification Within Equities Has Decreased The benefits of diversification within equities has fallen Implied Correlations 1.

75 0.50 -0.00 0.50 0.00 -0.00 1953 1963 1973 1983 1993 2003 Source: Goldman Sachs and Ibbotson Associates 9 .25 0.25 -0.75 -1.Trend 3: Equity and Bond Returns are Negatively Correlated 12 mth Rolling S&P 500 / Long- Long-term Government Bond Correlation 1.

II. How have investors responded? 10 .

Responses Investors have responded to the trends by 1. Using more index products 4. Reducing active risk 3. Looking for alternative sources of alpha This increases the importance of derivatives in markets: n Price discovery and leadership in derivative markets n Risks transferred from one asset class to another 11 . Reducing or hedging equity exposure 2.

15% Short Call(a) 0 0 (25) (20) (15) (10) (5) 0 5 10 15 20 25 (25) (20) (15) (10) (5) 0 5 10 15 20 25 30 (5) (5) (10) 60/40 Allocation (10) 60/40 Allocation (15) Equity Return (15) Equity Return n Altering the fixed income weighting reduces up and downside proportionally n Hedging strategies can be structured to trade off underperforman ce in a target return range for outperformance in declining markets Source: Goldman Sachs 12 . Response 1: Reduce or hedge equity exposure Hedging equity risk is an alternative to asset mix diversification Fund Returns for 60/40% and 40/60% Fund Returns on 60/40% Mix with Equity/Fixed Income Mix 1Yr Put Spread Collar on 1/2 of Equities 20 20 15 15 Fund Return (%) 10 10 Fund Return (%) 40/60 Allocation Hedged Portfolio 95/80% Put Spread 5 5 with 113.

Response 1: Hedge Equity Portfolio with Options Index options activity has been on a steep upward trend reflecting increased investor hedging … 300 Volume (Contracts) 200 100 0 S&P 500 EuroSTOXX FTSE DAX Nikkei 225 50 2001 2002 Q1 2003 Source: Goldman Sachs 13 .

Response 1: Hedge Equity Portfolio with Options … which has reflected itself in higher prices for downside protection 40% FTSE DAX 35% 30% 25% 20% 15% Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Jan-03 Feb-03 Mar-03 Note: 3 Month implied volatility skew divided by at-the-money volatility Source: Goldman Sachs 14 .

Response 2: Reduce active exposures Hugging Benchmarks Has Been Rational Holding the worst performing stocks has been especially painful 80 Rational responses include: Performance Relative to S&P 500 Best 50 Stock Portfolio § Minimize concentrated bets 40 § Diversify § Sell calls against large overweights 0 § Sell puts against cash to buy at target levels -40 The pain from holding Worst 50 Stock Portfolio the worst names has been greater than the -80 benefit from holding the 12/92 12/93 12/94 12/95 12/96 12/97 12/90 12/91 12/98 12/99 12/00 12/01 best names 15 .

Response 3: Investors Use More Index Futures Activity in futures has increased at the expense of stock volumes 4 2000 2001 2002 2003Q1 Futures to Stock Ratio 3 2 1 0 US Europe FTSE CAC40 DAX Pacific Source: Goldman Sachs 16 .

Response 3: … And other index products Other index like products have benefited Portfolio trading as % of NYSE Volume ETF volume as % of NYSE volume 25% 20% 20% 15% 15% 10% 10% 5% 5% 0% April' 03 99q2 00q2 00q4 01q2 01q4 02q2 02q4 99q4 Jan-97 Jan-98 Jan-00 Jan-01 Jan-02 Jan-03 Jan-99 Source: Goldman Sachs 17 .

1% -1.4% risk -20 Overwriting Strategy Return § Increase income -40 +1.8% Annualized Return (%) -3.6% returns -0. Response 4: Look for alternative sources of alpha Sell call options against individual names as an additional source of alpha Motivations Results § Low expected 40 -1.7% -2.4% +1.6% 20 § High volatility 0 § Reduce portfolio S&P 100 Return +1.8% 1995 1996 1997 1998 1999 2000 2001 2002 Note: Overwrite 25% of each stock position Source: Goldman Sachs 18 .

This has increased the importance of derivatives in markets: n Price discovery and leadership in derivative markets n Risks transferred from one asset class to another 19 .The increasing importance of derivatives Investor responses imply more derivatives usage.

500 -5 Net open interest delta EUR BN 3.500 Index Level -15 19-Sep-03 4.000 0 21-Mar-03 2.500 Positive net delta Negative net delta -25 5. Price Discovery in Derivatives Markets Example: Hedging demand by institutional investors determined th e level of the FTSE Delta Profile by Expiry Delta Profile by Market Move Market move Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 -10% -5% 0% 5% 10% 2.000 17-Apr-03 -10 20-Jun-03 3.000 -30 Source: Goldman Sachs 20 .000 19-Dec-03 -20 4.

Price Leadership in Derivatives Markets Example: Increasing call option demand at turning point in market Call/Put Ratio for FTSE 100 Index Options 6 4200 5 4000 FTSE 100 Index Level Call/Put Ratio 4 3800 3 3600 2 3400 1 3200 0 3000 Jan-03 Feb-03 Mar-03 Apr-03 May-03 Jun-03 Source: Goldman Sachs 21 .

Risk Transfer Between Equity Prices and Credit Spreads The relationship between equity prices and credit spreads have changed massively over the last few years This has coincided with a differing attitude to risk displayed b y investors The relationship between credit spreads and equity markets 1400 Jan99-Mar2000 Apr2000-Oct2002 Nov2002-May2003 US HY Credit Spread 1000 600 200 0 1000 2000 3000 4000 5000 NDX Level Source: Goldman Sachs 22 .

The convergence of equity volatility and credit The risk transfer resulted in implied equity volatility and credit spreads moving together 60 CDS 150: Average of 1mth 200 implied volatility 50 CDS 150 Levels Volatility (%) 150 40 CDS 150 Levels 100 30 20 50 Sep-02 Dec-02 Mar-02 Mar-03 Jun-02 Source: Goldman Sachs 23 .

What does it mean for your investment process? 24 .III.

Implications The world has changed so that funds are more likely to outperform if they can have n Flexibility and speed n Use of variety of instruments n Ability to search for alpha across boundaries These are the main differences between traditional active funds and hedge funds 25 .

0% 15% 20% 25% 10% 12% 14% 16% Std dev of return Expected Shortfall Source: Goldman Sachs Note: Based on hedging an S&P 500 portfolio for one year. All hedging strategies have a VaR or 18% calculated on 90% level of confidence and have lowest possible cost. Traditional vs Dynamic Strategies Traditional risk measures based on symmetric risk may fail to capture the correct risks in a dynamic environment Risk/Return Trade- Trade-off Downside/Upside Trade- Trade-off 8% 22.5% Put Spread Collar Futures Collar 4% 15. 26 .5% Unhedged Unhedged Put Spread Put Spread Put Expected Return Upside Potential 20.0% Futures Put 6% Put Spread Collar Collar 17.

Investment Styles: The choice between alpha and beta and use of derivatives Style Tools Beta Futures Emerging Markets Global ETFs Macro Growth Passive Fund of Funds Value Equity Finance Opportunistic Event Index Options Driven Market Neutral Single Stock Options Alpha Derivatives Usage Extensive Low Extensive Source: Goldman Sachs 27 .

low diversification.Responses and Implications to Recent Trends Recent trends in global markets n High volatility. equity bond dislocation How have investors responded? n More usage of equity derivatives What does it mean for your investment process? n You need to be fast and flexible and you really can use derivatives in your process 28 .

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